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Monetary Policy, Heterogeneous Expectations, and the Return of High Inflation

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  • Fabio Milani

Abstract

This paper studies the transition to high inflation during the COVID-19 pandemic, using a behavioral version of the New Keynesian model, which replaces the conventional assumption of Rational Expectations with subjective and heterogeneous expectations. Different shares of agents in the economy form expectations based on alternative views regarding future economic variables: 1) a share of agents forecasts that inflation and output will rapidly revert to steady state; 2) another share forms forecasts based on a model resembling the MSV solution under rational expectations; 3) a third share of agents uses an under-specified model that captures trend-following, adaptive, or extrapolative behavior. Agents learn over time the parameters of their perceived model and they can also shift across different views based on past forecasting performance. The macroeconomic model is estimated using Bayesian methods to fit realized macroeconomic variables and data on expectations from surveys. The results document an additional channel that operates through switches in agents' perceptions and amplifies the impact of the original inflationary shocks. In response to rising inflation after COVID, agents begin shifting from the mean reversion model to the trend-following specification (with a belief about perceived inflation persistence that is simultaneously revised upward). Consequently, the impact of inflationary shocks is magnified and the effects of monetary policy attenuated.

Suggested Citation

  • Fabio Milani, 2025. "Monetary Policy, Heterogeneous Expectations, and the Return of High Inflation," CESifo Working Paper Series 12123, CESifo.
    • Handle: RePEc:ces:ceswps:_12123
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    References listed on IDEAS

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    1. Carlos Carvalho & Stefano Eusepi & Emanuel Moench & Bruce Preston, 2023. "Anchored Inflation Expectations," American Economic Journal: Macroeconomics, American Economic Association, vol. 15(1), pages 1-47, January.
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    3. Branch, William A. & McGough, Bruce, 2009. "A New Keynesian model with heterogeneous expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 33(5), pages 1036-1051, May.
    4. William A. Brock & Cars H. Hommes, 1997. "A Rational Route to Randomness," Econometrica, Econometric Society, vol. 65(5), pages 1059-1096, September.
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    More about this item

    Keywords

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    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E65 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Studies of Particular Policy Episodes
    • E70 - Macroeconomics and Monetary Economics - - Macro-Based Behavioral Economics - - - General

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